East Capital’s Marcus Svedberg reviews reasons to be an optimist on EM
East Capital’s chief economist Marcus Svedberg notes there are reasons to avoid a negative consensus on emerging markets for 2014.
It is arguably not very easy to be an emerging market optimist these days. It seems like almost everything and everyone is against the group of markets that were once such investor darlings. Tapering is the most obvious cause for pessimism but there is more to it. The fact that economic growth decelerated and was revised down by most analysts for most of last year did not help. That, combined with concerns about longer term economic and political sustainability in a number of large emerging markets, resulted in weak stock markets during a year when developed markets rallied to new all-time highs.
But perhaps the biggest reason optimists like myself are struggling right now is because the policy response has been weak and in some cases even counterproductive. In Eastern Europe, which has been on a reformist path for the better part since the fall of the Berlin Wall, the reform momentum has slowed down considerably. The EBRD measures this on a yearly basis and has pointed out in its latest assessment that the number of country reform downgrades outnumbered the upgrades for the first time ever last year.
Fundamentals vs sentiment
But things are not necessarily as bad as they might seem. Sentiment tends to overreact and fundamentals are not all that bad, at least not if one has a selective approach to investments. We have been meeting a lot of clients lately asking them if they are fundamentalists or sentimentalists. For the fundamentalists, we have been arguing that are is still a lot of attractive macro and market fundamentals within the EM space. It is just not a general picture. Russia, for instance, looks very resilient to tapering from a fundamental standpoint due to its budget and current account surpluses, combined with low public debt and large currency reserves. The opposite is true for Turkey. China also looks pretty good whereas Brazil and India still seem a little vulnerable although better than Turkey.
For sentimentalists, we would recommend thinking about how quickly things can change. A fellow EM optimist, Daniel Salter at Renaissance Capital, pointed out that the consensus was very negative on US equities three years ago, Eurozone two years ago and Japan one year ago – and see what happened on those markets. There is reason to believe the sentiment will turn around on EMs too. The question is when. My guess is that it will happen once the cyclical recovery is confirmed and analysts start to revise up their now very gloomy outlook. This brings us to the last point.
Most economists were spectacularly wrong in their growth forecasts for some of the largest emerging economies last year. At the beginning of last year, the consensus was the Russian economy would grow more than 50% faster than it actually did in 2013. For Brazil, the miss was almost 40% while it was off by a third for India and South Africa. Ironically, the forecasts were most accurate for the economy most are worried about, China, where consensus only missed by a tiny 5%.
When you make such a big mistake, you are obviously very reluctant to make the same mistake again. So consensus now has relatively conservative forecasts for Brazil, Russia and South Africa. This may be a mistake since the cyclical recovery is likely to be considerable on the back of stronger external demand and low base effect. It may be biggest in Russia given its strong macro resilience to tapering, buoyant consumption and expected turnaround in inventory cycle (some economist claim destocking alone shaved off 1.8pp of GDP growth last year).
This does not mean that one should revise up the longer term potential growth forecasts for these economies, it just implies that sentiment could be wrong and that growth may very well surprise on the upside this year. Put another way, one can remain concerned about the structural/longer-term outlook and at the same time believe that growth will surprise positively in the short term.
Finally, the importance of distinguishing between opportunities in the short and long term as well as acknowledging the divergence within the EM space suggest that we should move away from general assessments of the asset class and, if possible, give up the fashion of catchy acronyms that tends to group countries together for the wrong reasons.